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Fixed Income Struggles For The Balanced Portfolio

Fixed Income Struggles For The Balanced Portfolio

Fixed income has been the whipping boy of the investment world for a while now. As stocks surged – interrupted only by a global pandemic – alternative strategies went mainstream, and DIY investing increased in popularity, the bond market has been beaten down by low interest rates. 

For the vast numbers of people who still have their money in a balanced portfolio, this could represent about 40% of their savings, despite experts and analysts long proclaiming the traditional 60-40 model extinct. 

But to appreciate fixed income’s struggles, it’s important to understand what a balanced portfolio is supposed to do. Typically 60% stocks and 40% bonds – although it’s a sliding scale – the aim is to provide a good level of long-term returns by way of a smoother ride. Returns compound over time and clients are not panicked into selling at crippling low prices. Stay invested, reach retirement and, bingo, you have enough cash to enjoy your work-free years and maybe even an annual cruise. 

But in recent times, the 40% of this equation has come under fire. Big-name investors sounded alarm bells that, to be fair, any advisor worth their salt was already hearing. Warren Buffett said early in 2021 that “fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future”. The backdrop to his comments was a bond market ailing despite the economic recovery gaining momentum. The underlying message from Buffett was that stocks are the best route to portfolio growth. 

Hedge fund guru Ray Dalio was equally blunt. “Don’t own bonds,” he warned in 2020, foreseeing that rock-bottom rates had nowhere to go but up. In early 2021, the Canadian 10-year Treasury nearly doubled from about 0.8% to 1.5% in just two months, while the yield from the 10-year U.S Treasury rose from 1% to 1.7% over the same period. The result? Bond prices were undermined and portfolios took a hit, although the blow was softened by the rally in equities. 

All eyes on central banks 

Of course, when interest rates go up, new bonds offer a higher rate and more income to clients. Yield, however, has been driven down by central banks’ lower-for-longer policy. Historically, rates were low even before the pandemic-induced crash of March, 2020 but with the U.S. Federal Reserve and the Bank of Canada eager to help their respective stricken economies, their benchmark rates have been zero-bound ever since.  

With unprecedented monetary and fiscal stimulus sloshing around the markets and turbocharging the economic recovery, speculation is rife about the timing of the Fed and the Bank of Canada’s QE tapering programmes, the prospect of spiralling inflation and, therefore, who will hike first. 

However, consensus is that any hike is unlikely before late 2022, with inflation rising but not spiralling out of control. Kevin Headland, Senior Investment Strategist at Manulife Investment Management, said: “While we do not believe that inflation will remain at these levels currently – near 5% – on a year-on-year basis, we do believe it will remain above the 2% level for quite some time.” 

This means bond markets have at least a year’s runway until rates might rise, making it an unappealing place to be with little immediate prospect of providing the type of returns a retiree needs. 

Attractive alternatives 

Fixed income’s reputation is not helped but the appeal of other asset classes. Bond traders were the ugly duckling after equities stormed back from the crash in record fashion. The new bull market has been sustained by sector rotation as long-time tech favourites gave cyclicals a share of the limelight. 

The pace has slowed and volatility is expected but Derek Massey, Head of Portfolio Management at HSBC Global Asset Management, proclaimed risk assets to be the “only game in town”. While warning against greed in the market, such as the meme stock saga, he pointed to the impact of the monumental stimulus packages. He said: ““Quite honestly, until interest rates start to rise, it really is back to that TINA acronym of ‘There Is No Alternative’. With rates as low as they are, a bond investor can’t generate much of any income. If they want to make a decent total return, then equities are the only game in town.” 

Elsewhere, the 60-40 mix has been further challenged by alternatives that not only offer diversification benefits but also attractive return potential. The likes of private credit, REITS, preferred shares, liquid alts, cryptocurrencies and gold have laid out their case for portfolio inclusion in recent months. According to Investopedia, Bob Rice, the Chief Investment Strategist for Tangent Capital, predicted that a 60-40 portfolio was projected to grow only by a rate of 2.2% per year into the future. His verdict: those who wished to be adequately diversified will need to explore other alternatives. From that perspective, fixed income once again looks the poor relation. 

The case for fixed income 

Of course, it’s easy to kick an asset class when it’s down. But doing so by focusing purely on returns overlooks the crucial job fixed income does in a balanced portfolio – to provide ballast and stability. If you have a long time horizon, this might not be of much interest but if you’re a few years away from retirement, it’s vital. 

According to Bloomberg Finance’s comparison of the global shares market, as represented by MSCI All Country World Index, against the movements of the global bond market, as represented by the Bloomberg Barclays Global Aggregate Bond Index, it’s clear that bonds still zig when equities zag. 

In recent years, when the equity market experienced a decline – in 2002, 2008, 2010 and 2011 – global bonds steadied the ship, offering crucial diversification that softens the blow and enables a faster recovery. 

Of course, this doesn’t happen every time. In 1994, both asset classes dropped when interest rates rose sharply, while bonds come with their own set of risks. But for the older investor who needs that volatility dampener, fixed income still has a role to play in helping clients meet their goals, even if it’s not producing the desired returns. 

What to do? 

Given the generally low yields and uncertainty over inflation and interest rates, short-duration bonds are getting lots of press because, while not earning much, they are a relatively safe place to be. 

Younger investors might feel comfortable taking on more credit or duration risk to get that yield up – and there’s nothing wrong with that if you have the appetite. But for those clients near or in retirement, investment grade, short duration offers less rate sensitivity but still earns more than money market funds, for example. 

For the more adventurous investor, there are other options. Emerging market debt not only has positive yields but the spread over Canadian and U.S. government rates are also positive. Take China, for example. At more than 3%, Chinese 10-year government bond yields are nearly 2% above 10-year U.S. treasuries. More yield and more diversification, what’s not to love? However, it’s not for the faint of heart, with the Chinese putting less emphasis on investor rights and the free movement of capital. 

Private debt is also an attractive alternative to the public high-yield market. Investors, of course, must be willing to forego liquidity in order to attain more favourable returns. And in addition to this illiquidity premium, private credit investors can also expect to earn a complexity and uncertainty premium for lending to markets with less opacity.  

For the average investor, though, there is a sobering overall takeaway: rein in your return expectations, unless you’re prepared to take on more credit, duration or illiquidity risk. With the economy looking strong, some investors may be in a position to do that but for elderly clients, caution is the watch word. 

Matt Brill, Invesco’s Senior Portfolio Manager and Head of North America Investment Grade, said clients simply have to adjust expectations. In May, the firm added some less liquid securities, up to 5%, and took on a little bit more high yield credit risk. It was unwilling, however, to take on more duration. Lowering your sights, Brill added, is better than reaching for yield to maintain the level of returns you’re used to. 

“If you do that, you’re taking on one of those three risks,” he said. “I’m more comfortable with some than others. I’m certainly not comfortable in duration right now, and I wouldn’t be comfortable for mom and pops to put on a lot of credit risk, because that’s not what they’re expecting out of their fixed income.” 

Bonds still have a role to play in your portfolio; preserving wealth is more important than home runs for many investors. But there’s no hiding that the going is tough for fixed income right now. With interest rate and inflation uncertainty heightened, be mindful and tamper expectations. 

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